On 15 September 2013, the world will mark the fifth anniversary of
the collapse of Lehman Brothers Holdings Inc, one of the largest investment
banks in the US. In 2008, the collapse triggered a global financial crisis. One
of the biggest reasons behind the financial meltdown in general and the
collapse of Lehman in particular was high leverage.
What is leverage?
- Businesses and individuals do not always
invest their own money.
- They use various types of debt instruments to
fund their business or investment.
- In the financial world, this is known as
leverage.
- Let’s say, a company has Rs.100 worth of shareholders’ capital and it wants to
expand its business, which needs another Rs.100 worth of
investment.
- There are two ways of raising this
capital—through equity or debt.
- If the company raises equity capital, the
shareholder base will increase and the earnings per share (EPS) will go
down.
- But if it raises money through debt, the EPS
will remain intact. In fact, the EPS will go up as soon as the new
investment starts generating returns. However, at the same time, the
company will have to service the debt taken and the overall risk will go
up.
Reasons and consequences
- Businesses generally use leverage to enhance
profitability, but too much debt can also become an existential threat for
many.
- This is exactly what happened in the run up to
the 2008 financial crisis. Both the household sector and the financial
world leveraged themselves excessively in the developed world.
- While individuals were buying housing
properties with borrowed money and had no ability to repay, the banks and
financial institutions were leveraging themselves to accumulate junk bonds
and derivative instruments based on the housing loans, among other
things.
- As the property prices started falling,
homeowners started defaulting and, suddenly, there were no takers for
those junk bonds.
- As a result, inter-bank lending froze and the
entire financial world came to a virtual standstill.
It was reported that at the time of bankruptcy, Lehman Brothers
had leveraged itself 44 times. Simply put, for every $1 of capital, it had a
debt of $44. At such high level of leverage, just about 2% change in asset
prices can wipe out the entire capital. Interestingly, Lehman Brothers was not
the first entity to operate at such a high leverage ratio. Long-Term Capital
Management, a hedge fund with two Nobel laureates on board, had to be rescued
in 1998 because of highly leveraged positions.
The bottom line
Firms take debt to enhance shareholders’ returns and it is not
always a bad thing. However, it is important to know the optimal level of
leverage a company can withstand. Too much debt can also destroy shareholders’
wealth.
